I recently derived the calculation of the relative strength index, an indicator that aim to spot overbought and oversold assets, but what is an overbought/sold asset ? Can such things be estimated with price alone ?
This why i propose a modification of the relative strength using my recently proposed efficient calculation including volume information in order to spot overbought/sold asset.
Scaling A Liquid Market
The relative strength index detect an overbought/sold asset when higher/lower than a certain level, often 80/20. An overbought asset, or better say over evaluated, is more attractive to sell because prices are no longer attractive to buy, it has reached its value of interest for traders looking to go long, we can then expect the price to correct and start a trend of opposite direction, while an oversold asset is more attractive to buy based on the same logic.
The idea of talking about overbought and oversold without taking into account the volume can be a bit strange, since volume is directly related to the quantity of contracts traded, an higher volume can show sign of a more active market, which can describe the terms : overbought/sold a bit better. Many indicators used the rsi framework with volume, the money flow index for example, but it can be interesting to provide other alternatives.
The Indicator
The indicator is based on the average positive changes in price multiplied by positive changes in volume divided by the average absolute change in price multiplied by the absolute changes in volume. The average is based on the wilder moving average which is a simple exponential filter with smoothing constant 1/length.
The indicator will react according to the volume magnitude, higher volumes will make the indicator go over/under the overbought/sold threshold more easily, in the image above, the indicator is currently saying that the market is under evaluated, which is not the case for the RSI. Such situation allow us to take a position that we could't take if we base our judgement only on price change magnitude.
The indicator has a tendency to be over/under the thresholds a longer period of time if the volume is relatively high.
An interesting effect the indicator has it to ignore movements with moderate volume, the indicator is less prone to cross under a threshold and to go back to it, this is shown in the image above. Another observation we can make is that the proposed indicator is smoother than the rsi, this is certainly due to the fact that the volume underweight small price changes.
Conclusions
I proposed a modification of the relative strength index that also take into account volume information. The proposed indicator is also smoother. Regarding its ability to detect overbought and oversold market, it has indeed the capacity to do it, however the problem remain the same, what is the extent of the correction following an overbought/oversold market ? We can see that the correction can be minor, and thus be followed by a large movements correlated with the main trend.
With those oscillators we are interested into knowing the end of the "whole trend", and they fail to do this because they use past information. I still hope the indicator find some creative usages amongst the community.
Thanks for reading ! And remember to ask before using the script code, it pains me to see minor changes on scripts i can pass 3 hours on.
How is it you have all this time to help make us smarter? Thank you for your generosity
alexgrover
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@faith_defender, I'am rich in time and willing to share it, thanks a lot for your comment and support :)
mariuspe
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@alexgrover, Thanks Alex, really appreciated. I want to test out your indicator. Did you make other modifications?
alexgrover
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@mariuspe, Thx for your support, no modifications have been made to this indicator at the moment, if you have suggestions feel free to pm me.
LucF
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It is a great privilege to see this genius-level work grace the Public Library. And if that wasn't enough, you have Feynman's gift for teaching. Once again, respect, Haiku Master.
alexgrover
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@LucF, Thanks a lot for the support, it means a lot to hear that my teaching is easy to comprehend :)
Please upload your consciousness into a machine so we may never be without your creativity :D
alexgrover
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@theheirophant, I'll work on it ;) Thanks a lot for you support.
aaahopper
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Great work again.
I am glad you have done this indicator. It correctly identifies that an oscillator is in the "overbought" region (subject to setup) means current strong uptrend while and "oversold" conditions is strong down-trend.
This is extremely helpful.